The IRS Has its Eye on

I have gathered from several responses to my prior post on “C” corporations versus “S” corporations that many active real estate investors prefer the “S” status. The reasons cited for “S” status are flow through tax treatment, i.e., you do not have a separate taxable entity to contend with, and employment tax minimization.

For many business owners, it is the second reason that piques their interest. The allure of escaping 13.3% additional tax on the first $106,800 in earnings is a tempting treat that is difficult to ignore when it feels like every governmental body is out for a piece of your earnings. (Note. Any wages above 106k are subject to 2.9% Medicare tax.) This is exactly what inspired Mr. Watson in 2002 and 2003 to keep his salary at $24,000 and take distributions of $175,000 annually.

As with most strategies, everything works out until it is challenged and its constitution is tested. The IRS recently challenged Mr. Watson and a district court concluded that Mr. Watson’s salary was unreasonably low, and allowed IRS to reclassify over $134,000 as salary. This cost Mr. Watson over $48,000 in taxes, penalties and interest.

As a real estate investor, you might be wondering how do you determine a reasonable salary? Obviously, each situation will be different so the IRS issued Fact Sheet 2008-25, that lists some factors that courts have considered in determining reasonable compensation:

training and experience;
duties and responsibilities;
time and effort devoted to the business;
dividend history;
payments to non-shareholder employees;
timing and manner of paying bonuses to key people;
what comparable businesses pay for similar services;
compensation agreements; and
use of a formula to determine compensation.

Many of the items on this list center around the amount of time and effort you devote to your business. If you are the sole employee in your real estate corporation then it is reasonable to conclude that your salary will be on the higher end of the spectrum. A rule of thumb that I tell my clients is at a minimum, factor on a 50/50 match on the first 110k in revenue.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.